RLPC: CLO spreads remain stubbornly high

Published 5:37 PM ET Sun, 11 Nov 2012

By Billy Cheung

NEW YORK, Oct 12 (Reuters) - Demand for collateralized loan obligations (CLO) remains robust as September saw managers price $6.7 billion of new vehicles, making it the busiest month for issuance in what is already the busiest year since 2007. Despite a thriving leveraged finance market and a similarly strong CLO market, spreads on recently raised AAA rated CLO tranches hover stubbornly above those printed last spring.

Last week, Apollo Global Investors launched a $722 million CLO, the largest CLO this year, with the AAA tranche pricing at 142bp over Libor. That pricing is somewhat typical of recently issued CLOs, with spreads continuing to trade in the 145-150bp range. By contrast, CLO managers were printing AAA paper at spreads in the low 130s during early second quarter.

In some ways, CLOs are a victim of their own success, as surging issuance is contributing to wider spreads.

"Given the supply of new CLOs coming to market, investors can be choosy and pick the best terms," said Matt Natcharian, head of structured credit for Babson Capital . "As long as loan spreads stay north of 400bp, new CLO deals still work, but AAA tranches are trading the cheapest on a fundamental credit risk basis. The rally in bank loans should cause AAA spreads to gradually come in."

Currently, the LSTA/Thomson Reuters LPC's SMi100 average, which tracks the trading levels of the 100 largest North American syndicated leveraged loans, indicate loan spreads of 436bp over Libor and loan prices at a multi-year high of 98.5 cents on the dollar. At the end of first quarter, spreads and loan prices were 453bp and 97.67, respectively.

The same trends apply for new loan issues. According to Thomson Reuters LPC, primary yields on large corporate and middle market loans are currently at 5.5 percent and 6.48 percent, respectively, down from 5.78 percent and 7.64 percent at the end of the first quarter.

While higher loan prices and lower spreads should support tightening AAA spreads, minimum Libor levels on loans, or Libor floors, may be helping to delay spread contraction. Thomson Reuters LPC Collateral calculates that 74 percent of loans owned in 2012-issued CLOs contain Libor floors with these floor averaging 130bp. With CLO liabilities based on a three-month Libor rate of around 34bp, CLOs are able to capture the additional 1 percent spread difference.

Another headwind to tighter AAA spreads in the near term is the different investor base for CLO liabilities and leveraged loans. The largest buyer of AAA liabilities has historically been banks. Since larger banks tend to borrow close to Libor and can obtain favorable regulatory capital treatment for owning AAA rated assets, they can earn positive returns from buying CLO AAA tranches that leveraged loan investors often cannot.

"The investor base for AAA tranches is very different from those who buy individual leveraged loans," said Rishad Ahluwalia, global head of CDO research at JP Morgan . "The AAA investor has been used to wide spreads for a while, especially relative to other structured asset classes like ABS and CMBS. Fed action combined with relative value for AAA CLOs could force spread tightening in the absence of macro shocks."

Since the Federal Reserve's announcement in mid-September of a third round of quantitative easing, the search for yield has intensified. Asset-backed AAA tranches for U.S. commercial mortgage backed securities (MBS) and dollar-denominated U.K. residential mortgage backed securities are now generally trading at spreads below 100bp as government policies target housing markets.

The Fed's QE3 intention to purchase $40 billion of MBS per month should continue to reduce securitized product supply, though investors still differentiate among the underlying assets for various asset backed liabilities.

For example, under the Treasury's expired Term Asset-Backed Securities Loan Facility program, the Federal Reserve supported investor purchases of certain types of asset backed securities, including student loans, credit cards, and autos, with non-recourse financing. CLO liabilities did not qualify.

"People tend to be more nervous about highly leveraged companies serving as the underlying collateral, but the credit crisis proved the CLO model, as no AAA's took losses," said Michael Kessler, a credit strategist at Barclays in New York. "There seems to be some disbelief that AAA tranches are truly AAA. To get further spread tightening, the market likely needs incremental buyers to step up."